7 months ago 9 min read

Tokenomics: What and Why it is Important

Table of Contents

Tokens are one of the many digital assets that are constantly in demand in the crypto market. Tokenomics is the study of the economics of cryptocurrencies or digital tokens. Fundamentally, it entails researching the variables that influence the supply and demand for tokens. The creation, distribution, and quality of cryptocurrency tokens are among the criteria. What are crypto tokens, though, and why are they so well-liked? To assist you in understanding tokenomics, we peel back its many layers.

What Does a Crypto Token's Tokenomics Entail?

In case anyone needs a refresher, a crypto token is essentially a cryptocurrency coin based on a blockchain platform that can be swapped with another blockchain and that offers its holders a number of benefits.

Tokenomics now. The words token and economics are combined to create the phrase. To sum up, the term "tokenomics" refers to all the characteristics of a crypto token that appeal to investors. It simply relates to the economics of a crypto token. The project whitepaper will typically go into great detail on the tokenomics for a certain crypto token, which should make it easier for you to understand the token's functionality, goal, allocation scheme, and other aspects.

Why is Tokenomics Important to Investors?

For the following reasons, it is crucial for investors to understand the demand and supply dynamics of the cryptocurrency market:

🔹 It explains how the cryptocurrency market has performed recently.
🔹 Tokenomics aids in estimating an asset's future value.
🔹 It provides information about which crypto asset will be more profitable in the long run.

Investors should keep in mind the following aspects that make tokenomics more accessible:

🔹 You should become familiar with using digital money and understanding how the services being developed relate directly to the digital asset.
🔹 Learn the total number of tokens in existence, the future stock limit, and the creation date.
🔹 Do your research on the owner of the digital coins and whether any are being held back for later release to coin developers.

Why is Tokenomics Important for Cryptocurrency Investments?

Value investing legend Seth Klarman explains in his famous investment book, Margin of Safety, that "in the short run supply and demand alone determine market prices." If we believe that to be true and that it applies to crypto assets using blockchain technology as well as the stock market, then understanding the factors that will impact either supply or demand is critical for both speculators and investors.

In that case, there are several factors to consider when studying crypto tokenomics. The most important consideration is understanding how the digital currency will be used. Is there a clear link between the asset and the use of the platform or service being built? If there is, there is a good chance that a growing service will necessitate purchases and usage, which will help to raise the price. What can the token be used for if there isn't one?

Other critical questions to address include the following:

🔹 How many coins or tokens are there now?
🔹 How many will there be in the future, and when will they appear?
🔹 Who actually owns the coins? Are there any set aside for future release to developers?
🔹 Is there any evidence that a large number of coins have been lost, burned, deleted, or are otherwise unusable?

Affecting Factors for Crypto Tokens

For every beginner just getting into the realms of cryptocurrency, it is important to know the factors that might even remotely affect the value of a crypto token.

1) Token Distribution and Allocation

How a crypto token is distributed is one of the primary factors that determines its value. There are two ways to generate crypto tokens: pre-mining or a fair launch. The term "fair launch" refers to the fact that a cryptocurrency is mined, earned, owned, and governed by the community from the start. It is a decentralized network with no concept of private allocation. However, with pre-mining, a portion of the coins are created (mined) and distributed prior to their public release. In an initial coin offering, a portion of the coins are sold to prospective buyers (ICO). This is a method of rewarding early investors, miners, and founders with newly minted coins.

To ensure that the project you're investing in is legitimate and ambitious, make sure it distributes its tokens to prospective users.

2) Token Supply

The supply of a token is a critical parameter to consider when studying the tokenomics of a cryptocurrency. For crypto tokens, there are three types of supply: circulating supply, total supply, and maximum supply. The number of cryptocurrency tokens in circulation is referred to as the circulating supply. Meanwhile, total supply is the number of tokens that exist today minus all tokens that have been burned. It is calculated as the sum of tokens currently in circulation and tokens that have been locked in some way. Finally, total supply should not be confused with max supply, which is the maximum number of tokens that will ever be produced.

Noticing a token's supply can be a good predictor of its future. Active mining is used by developers to increase the circulating supply of a token. If the circulating supply continues to grow, investors can expect the token's value to rise. On the other hand, if too many tokens are issued, the value may fall as well.

3) Token Market Capitalization

The market capitalization or market cap of a cryptocurrency is a metric used to determine the popularity of the token. It is calculated by multiplying a token's current market price by its circulating supply. Even in the long run, the market cap is a good indicator of the token's value. As a result, small-cap cryptocurrencies are riskier. While large-cap cryptocurrencies often promise better returns and safety.

4) Token Model

Every crypto token has a model that determines its value in the end. Some tokens are inflationary, which is why they do not have a maximum supply and can continue to mine indefinitely. Deflationary tokens, on the other hand, have a token supply that is limited to the maximum supply. Deflationary tokens are useful for avoiding unsold coins in circulation and are usually unaffected by market volatility. Inflationary tokens, on the other hand, do a good job of incentivizing network miners, delegators, and validators.

5) Price Stability

Tokenomics also emphasizes the importance of researching the implications of price stability. Cryptocurrencies are known for their volatility, which may not always work in the investor's favor. Fluctuations can frequently lead to dwindling investor interest. Furthermore, fluctuations can lead to network restrictions.

Investors should ensure that the project is taking every precaution to avoid such fluctuations. The problem could be solved by ensuring that there are enough tokens to match the supply levels. This would help to stabilize the price, allowing investors to use the tokens for their intended purpose. Tokenomics can also assist developers in price stabilization by establishing equilibrium.

Types of Token Models

A Token Model is the token economy in a blockchain project's ecosystem. This also comes in different types.

1) Inflationary

An inflationary token, like the US dollar, will be continuously printed/produced over time with no maximum supply.

Inflation is still widely misunderstood. Inflation is defined as a decline in purchasing power rather than an increase in asset prices. If another 10% of a currency is released into the market, the real value of that currency will fall.

The majority of proof of stake tokens, such as Ethereum and Polkadot, are inflationary in order to reward network validators and delegators who are in charge of validating transactions within the blockchain network. Cosmos(ATOM), for example, has an inflation rate ranging from 7.5-20% depending on the total amount of coins staked.

While not a cryptocurrency, the USD is an inflationary currency.

However, some cryptocurrencies, such as Dogecoin and Grin, have an infinite supply. This also means that their token supply is limitless. Dogecoin's circulating supply was 131.13 billion in September 2021. Doge's infinite supply makes it inflationary, and it is this tokenomics that has made Doge so popular.

Another aspect of tokenomics is the burning of specific coins in order to reduce supply and inflate coin and token value. More tokens are burned as a digital coin is used.

2) Dual Token Model

In this model, two distinct tokens are used on the same blockchain, one as a funding option and the other for utility. Regulations imposed on unregulated ICOs have resulted in this new type of model. Aside from the added security, dual tokens allow projects to be more flexible because both tokens can have their own properties.

Examples: Vechain and VechainThor (VET/VTHO), MakerDAO (MKR/DAI)

VET is the primary token of the Vechain blockchain, and its primary function is to transfer value across the blockchain and trigger smart contracts. The 'energy' token, VTHO, serves as gas to power smart contract transactions. Every VET produces VTHO at a rate of 0.000432 per day. VET can be staked by users to generate VTHO.

3) Deflationary Model

Bitcoin has established a deflationary token model as the industry standard. In this model, there is a fixed number of tokens that can be created, and that limit is never increased. This results in a deflationary currency in which supply does not increase in tandem with demand.

🟢 Pros: As the supply of tokens is depleted, natural demand arises. It also eliminates the fear of inflation that plagues fiat currencies.

🔴 Cons: Some question whether the incentive structure of a deflationary model will eventually lead to its demise. Users are incentivized to hoard tokens rather than spend them because the number of tokens produced is limited. Without sufficient spending, most tokens will fall out of circulation, and the token itself will lose value.

Examples: Bitcoin (BTC), Cardano (ADA)

4) Asset-Backed Model

Some cryptocurrencies have backed their tokens with another asset. Users can derive the value of the token from the value of the token's underlying assets in this asset-backed model. Tether, the most well-known (and highly contentious) asset-backed token, claims to be backed by the US dollar.

🟢 Pros: With proper transparency, asset-backed tokens can generate stable digital assets, removing unwanted volatility in cryptocurrencies.

🔴 Cons: Is this model truly transparent? Just ask Tether, which claims to have US Dollar reserves equivalent to the token supply. Skeptics have called this into question numerous times (not to mention the US Department of Justice).

Examples: Tether (USDT), Dai (DAI)

Use Cases for Token Economics

The study of token economics is a vast field, with new trends and principles emerging on a daily basis. It is important to note, however, that use cases also define the direction of tokenomics price evaluation. The study of various token economics use cases could provide a detailed impression of how it can define the future of crypto and blockchain technologies. Here are some notable applications of token economics.

1) Staking

Staking is one of the important topics covered in a tokenomics guide. In staking, the network stores value in a wallet, and validators with more value in their wallets have a better chance of receiving massive rewards for verifying transactions. The Delegated Proof of Stake model is an excellent example of token economics in staking. The primary distinction between this model and a PoS model is the use of random delegation and selection. As a result, participants with the highest stakes may find it difficult to receive validation rewards on a consistent basis. As a result, it provides a credible approach to wealth distribution.

2) Value of Exchange

The most common example of tokenomics use cases also refers to their use for exchanging value. Bitcoin is a powerful example of token economics use cases for value exchange. Ethereum has successfully demonstrated that token projects can use token economics to both exchange and create value. It can use token economics to encourage fundraising as well as the launch of decentralized applications.

3) Project Contributions

Among the many tokenomics use cases in 2021 were contributions for project development. The STEEMIT example clearly demonstrates the potential use case of tokenomics for encouraging project contributions. STEEMIT users are rewarded with tokens for their efforts as content creators, moderators, and commentators.

Furthermore, the platform incentivizes users to direct traffic to content that is relevant to their interests. The rewards for content creators, moderators, and commentators have the potential to significantly contribute to the growth of the STEEM platform. Users could cash out their token rewards in STEEMIT dollars in exchange for their contributions to the development of a larger and better STEEMIT platform.

4) Tokenomics Value

The final point to mention in a tokenomics guide is the value it brings to the table. Token economics could aid in reflecting on the economic and social costs associated with token projects. This is an important requirement in an era when tokens can be used to represent almost any real-world asset, including precious metals, real estate, artwork, and collectibles. Most importantly, tokenomics is essentially capable of providing the value of community-based solutions that align with the values of consumers.

Tokenomics in Cryptocurrency Value Determination

Tokenomics can also be used to forecast how much an asset will be worth in the future. Many newcomers to cryptocurrency, for example, will believe that "if this coin becomes as valuable as Bitcoin, then one day..." when, in reality, this may never be possible. Consider the two previously mentioned coins, Bitcoin Cash and Tron. Because Bitcoin Cash has the same total supply as Bitcoin, the idea that one might become as valuable as the other in the future has some validity — it is possible. However, with over 100 billion Tron in circulation, for one coin to be worth thousands of dollars, Tron would have to become the most valuable business in history — how likely is that?

While these questions may appear to necessitate complex answers, they will provide an additional perspective on crypto assets and aid in determining whether one asset is more likely to have a bright future than another.

Guide's Coda

Tokenomics is critical to the operation of a blockchain or dapp. It employs a set of hard-coded rules and a token to align all actors' behavior in a way that benefits the protocol. As we have seen, there is no single effective tokenomics model. There are several recipes for good burgers that use different ingredients to produce different flavors. The right combination of ingredients is essential for each recipe. Tokenomics vary depending on the blockchain services provided.

Four ingredients are required. The first is overall supply and demand. The number of tokens in circulation must correspond to the amount of token demand. The second component is the initial distribution of the token. It must incentivize all network participants while causing no harm to anyone. The third component is token distribution after the initial token distribution. It must be made dynamically and correctly reward participants without diluting the value of the ecosystem. Finally, value accrual adds value to the token and secures its place in the ecosystem.

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